Crisis Inevitably Breeds Leviathan

Yesterday, Christopher Dodd, Chair of the Senate Banking Committee, released the Committee’s discussion draft for financial reform. Leaving aside the fact that the Financial Crisis Inquiry Commission has barely begun its task of researching the causes of the crisis, it is hard to find anything worthwhile in this draft or the House variant.

Moreover, while the draft has been offered in the context of regulatory simplification, it removes a single agency (Office of Thrift Supervision) and replaces single agency with three more (Financial Institutions Regulatory Administration, Agency for Financial Stability, and Consumer Financial Protection Agency). Crisis breeds leviathan, and this crisis is no exception.

Consumer Financial Protection Agency It seems that Congress overall is fine with eliminating federal preemption and is destined to continue to push the original idea further down the road. The issue may be a Constitutional one, however, and I am sure the ABA will continue to object, which will cause more debate and delay for the bill.

Agency for Financial Stability This is the much-vaunted “systemic risk regulator.” The regulator, however, will mostly just be a committee of the heads of other regulatory agencies. The committee, however, leaves out the Federal Reserve Bank Presidents, which are proving an important voice of reason in the current economic debate. Moreover, it is still unclear what is meant by “systemic” and what actions are to be carried out. In reality, without clear operating objectives and authority, the Agency will be paralyzed by lawsuits and appeals if it attempts to take action against a company.

Resolution Authority The FDIC seems to have won resolution authority in all the variants put forward, a crucial victory since resolution requires maintaining special skill sets in valuation and negotiation that need not be duplicated.

Financial Institutions Regulatory Administration The “single regulator” is expected to encompass not only state bank oversight, but also bank holding company oversight. While everyone saw the bank part coming, I am not sure anyone anticipated removal of holding company oversight form the Federal Reserve. I think the Federal Reserve may have something to say about this before the debate is through, which will cause more debate and delay for the bill.

Moreover, recall that supervisor responsibility is layered, so that, for instance, a nationally-chartered bank is primarily supervised by OCC, and secondarily by FDIC and Fed. Are we to read the intent in FIRA as one to remove the secondary supervision capacities? As European governments are learning from the other direction, some interaction between central bank and supervision is desirable. Otherwise, how is the Federal Reserve supposed to, for instance, run the payments system without regulatory oversight with respect to reserve requirements? A balance will have to be stuck between the Federal Reserve Banks and the FIRA before this idea can even be considered. The proposal is not as simple as it looks.

OTC Derivatives Reform Still the same, with all the same problems. Congress is still trying to dodge the bullet over exactly which products should trade on exchanges, most recently by hiving that off on the SEC and CFTC. Currently, the idea has good intent but little chance of making any meaningful change. Moreover, even if implemented, it would not prevent the repeat of exactly the same crisis, because bank regulators still would not know counterparty risks in innovative financial products. Better suggestions will be coming in the next week, but we will have to see if they survive negotiations.

Hedge Fund Registration This is politically popular, but economically minimal. Registration is not regulation and, besides, it is not clear that even regulation will help reduce risk. Markets will just find different places to transact. We should not regulate to push risk off of the radar screen, but to be better able to track the risk that exists.

National Insurance Monitoring Like registration of hedge funds, it is not clear what the authority will encompass. Debate over offering a national insurance charter has been going on for decades. Perhaps that is a better solution than “monitoring.”

Credit Rating Agencies As mentioned in my last couple of commentaries, liability is the key provision here and liability, by itself, will make little difference. Liability for what? As long as we have First Amendment protection, liability is moot. We need statistical objectification and backtesting. The rating agencies want statistical objectification and backtesting. It probably won’t happen.

Executive Compensation Again, as I wrote recently, the link between compensation and risk taking is sensible, but not at all clear or established even in academic finance. This is another populist provision that has little chance of making a difference, economically.

SEC and Improving Investor Protections This is Congress’ interpretation of what the SEC needs. The SEC needs to get more involved in this debate over resolving their problems. Much of what is provided here merely moves the bar for the definition of “investment advice,” which will not help pensioners that are suffering because of poor institutional investor choices. The single provision that is useful here is self-funding, but given current fiscal strains I doubt it will survive.

Securitization Reform I have commented on this extensively in the past. Without standalone deals that could be economically transferred to other servicers and seeing too many points of contact between issuer and deal performance, issuers had too much “skin in the game” and regulators could not, therefore, promptly and properly resolve insolvent securitizers.

Congress, FASB, and bank regulators need to recognize that while securitization does not pass along all the risk of the loans, it does not pass along none of the risk of the loans, either. Therein lies one of the key accounting challenges to securitization: whether to treat the loans as off- or on-balance sheet. In fact, the answer is “neither.” Dealing with that subtlety is the key policy challenge that will make securitization a self-sufficient and stable means of funding, but it is a policy challenge that remains unpursued.

Municipal Securities Municipal borrowers got carried away in the bubble just like borrowing firms. They don’t need protection, so much as less devolution for fiscal responsibilities from a Federal government that expands spending without funding. As municipalities bore more of the fiscal responsibility, they borrowed more to meet that responsibility. Therein is the reason to stop, not continue, the expansion of government – at least temporarily – while funding can be realistically reassessed. There is no issue here, save that created by Congress, itself.

In summary, without a clearly articulated research into the causes of the crisis – including Congress’ own role in those causes – Financial Reform is still just a political exercise that needs to be undertaken prior to the mid-term elections. Much of what has been proposed from both the House and Senate is really just a mash of old issues, populist knee-jerk responses, and cover-ups. Let’s let the Financial Crisis Inquiry Commission get to work and help them undertake a meaningful inquiry that can increase the quality of the debate and the ensuing legislation.

One Response to "Crisis Inevitably Breeds Leviathan"

Anonymous ibid. November 13, 2009 at 6:22 pm

This is pretty obscure writing. For example, the sentence “…while securitization does not pass along all the risk of the loans, it does not pass along none of the risk of the loans, either…” could be said more simply, “…securitization passes along some of the risk of the loans…”Would you please consider writing simply, as you would if you were trying to explain it in private to a neighbor or to your wife? I read an enormous amount, and decoding complicated formulations fatigues the mind.